A new breed of traders has come into the market: they trade on momentum rather than on proper research
Patrick Mathidi Three months ago, we saw the Nasdaq shed 25% of its value. On one Friday alone it experienced a 355-point drop, to 9,7% below opening levels. Yet the following Monday it surprised everybody by bouncing back with its largest point increase of 217,87 points to 3538,96 – a gain of 6,5%. This severe volatility can frequently be explained by the presence of a new phenomenon: day traders. They come into the market to trade on momentum rather than on proper research. They are in for the quick buck.
At present, 25% of the United States market is traded by day traders; not surprising when one considers that the average American household has 32% of its wealth invested in the stock exchange. Day traders set margins, which is an amount of money placed with a broker, that the investor is prepared to lose. They then gear themselves by investing to a greater extent than their margin call allows. Say for example the margin call is $1-million, the investor can have a $10-million investment in the market. This means that the market must drop by up to 10% before the investor needs to raise more cash to top up his margin call account.
Obviously, the big trick is to buy and sell all within a day so that the investor does not need to lay out the capital in the case of a purchase, or borrow the scrip in the case of a short-sale. In a market that is characterised by sharp and rapid intraday price movements, money can be made or lost fairly easily if the investor is caught on the wrong side of the market.
Day traders sell the shares short when the expectation is for a weak market, hoping that the price will fall hard enough for them to buy it back later at a lower price. They buy the share upfront, when they expect the price to run. At this point they will sell it and realise the profits. It is believed some investors actually buy and sell the same share up to 100 times a day and tend to play on the same shares because they get to anticipate the volatility of the price fairly well. The sluggishness of the Nasdaq in previous sessions had raised expectations that there would be a rebound in stock prices. Naturally, a typical day trader would have gone in to buy all the battered shares when the market opened. However, things did not turn out as expected as the market showed further weakness. As the market falls, the obvious thing for a day trader to do is to sell the shares bought and try to realise some profit, if any.
But as more and more investors try to sell, buyers, who tend to be the institutional investors, choose to stand by the wayside and see how far the market will fall before lending support. For a day trader with a $10-million position, the book losses continue to grow, increasing the pressure to cut the position. Their first line of defence is the margin call; when that has dried up they have to finance the losses from their own pocket. It becomes a vicious circle. As the prices fall further, the desperation to sell causes prices to drop even further – especially when that much sought-after institutional support is not forthcoming. Once the prices appear to have bottomed out, companies with very sound fundamentals are suddenly trading at a very attractive low price, and the institutions, which have a lot of capital, become aggressive buyers. Although these shocks will shake out the “weaker” traders, the volatility caused by day traders is very much a function of the market. And it is when the long-term participants, the institutions, become active buyers that one can see the market race up again, like it did on Monday. Day traders muddle the market. It is back to that age-old lesson – do your homework well by investigating the companies before you invest in them, and stay in for the long-term.
Locally, we have seen that harsh lesson being learned by some investors on several of our small cap stocks. Some of those investors are still paying off losses incurred.
Patrick Mathidi is a dealer for Investec Asset Management (formerly Investec Guinness Flight)